How The Fed’s Forecast Fallacy Leads to Stagflation

The commodity boom’s bust is filtering through to the group of people who figure this sort of thing out when it’s too late — the analysts. The Australian reported over the weekend that things are looking dicey for jobs and infrastructure projects:

‘Slumping commodities prices and a flight of global investment to quality projects mean up to two-thirds of the nation’s 950 planned and current resources and infrastructure projects may not be realised, potentially slashing more than $300 billion of development spending and 150,000 jobs, according to ANZ.’

The reason analysts, who are supposed to predict things, are always one step behind, is because they look at the past. If resource companies made plans in the past, then that’s what analysts expect them to do in the future. Only once the plans are changed do the analysts realise what is up.

Unlike with analysts, every now and then it’s time to have a listen in on the policy makers. What they say and what they do is very different. The first one is funny. The second is terrifying.

The American central bank, the Federal Reserve, has decided that pumping money into the economy creates jobs. They just have to print enough (that’s the funny part). And so now their policy is open ended, meaning they’ll print more and more money until unemployment falls (the terrifying bit).

The problem is that unemployment and money printing aren’t related to each other in the way central bankers expect. They learned this back in the 70s when many countries experienced high inflation and high unemployment at the same time.

It was supposed to be impossible. How can prices rise if there are lots of unemployed people? Well, those unemployed people aren’t producing anything, so you have more money chasing fewer goods. The result is higher prices.

Anyway, the central bankers forgot that lesson, even though it has the catchy name of stagflation. The question for you is; will investors have to learn that stagflation is possible again? Or will they invest accordingly before it gets a grip on their wealth?

The tough part of investing for stagflation is the volatility. Prices are rising because of inflation, but the economy isn’t productive. No wonder the stock market gets confused. It doesn’t know whether to go up or down, so it does a bit of both. But it won’t be as confused as the central banks causing the problems. There are two reasons they will be caught out by stagflation again.

When the Fed makes its forecasts for the economy, it does so assuming ‘appropriate policy’ on the part of its policy makers. But here’s the trick. The definition of ‘appropriate policy’ is whatever policy it takes to get the desired results.

In other words, they believe they have complete control of the economy, so they are just forecasting what they are going to do. That’s why the Fed’s forecasts are always so positive.

Making forecasts when you think you can achieve whatever you want is a little odd. But the Fed employs vast amounts of economists to do just that. All this assumes that policy has control and can achieve whatever economic outcomes are desired. Never mind the reality of what we actually experience over and over again.

Fed policy also assumes something called linearity. Linearity is the idea that if you do one thing and get a certain result, doing the same thing will get the same result. If the first trillion dollars of money creation didn’t result in inflation, the Fed’s models will predict the same for the second trillion.

That’s a simplification, but you can see the problem. Physics, biology, chemistry and men are linear. Economics and women just aren’t.

The best way to think about non-linearity comes from Jim Rickards. He’s the global expert on currency wars, which is when countries around the world try to out-export each other by cheapening their currencies. Here’s his non-linearity example:

If one person runs out of a theatre during a film, nothing much else will happen. The same if two or three people jump up and do a runner. But if five people go at the same time, two more panicky individuals will think something is up.

Once they get up and make for the exit, another five people get jumpy about the sudden exodus of 7 people. They won’t want to risk whatever must be wrong, so they leave too. Next thing you know, everyone is making for the exit.

Even though nothing much happened when the first four people left, at some point a critical threshold is reached and the mad rush out of the theatre is triggered. Once it starts, it won’t stop. Now why might people want to escape the financial theatre of life?

Perhaps because the financial world is fake. Its key asset, money, can be created at will. And the new money always flows to the banks first. Why participate in a game that is rigged?

The problem with non-linearity is how difficult it is to predict. You can’t really model it on past behaviour very accurately. And you don’t really know what’s in the mind of individual theatre goers. But what you can know is whether there is a reason why people might want to flee. Right now the big hint is that, even if the American stock market has recovered, the real economy hasn’t.

In fact, it’s been getting worse in the land of money printing, according to the Weekly Standard:

‘Amazingly, incomes have dropped even more during the “recovery” than they did during the recession. In fact, they’ve dropped more than twice as much as they did during the recession. From the start to the end of the recession, the real median income of American households fell $1,413, or 2.6 percent. From the end of the recession to the present day, it has dropped $3,040, or 5.7 percent. This begs the question: What kind of “recovery” compares unfavorably with the recession from which it’s ostensibly recovering?’

This is what you should expect when central bankers and governments paper over problems. Problems are problems because it’s not much fun correcting them. But pretending there isn’t a problem makes it worse.

So the more central bankers hide the vast amount of debt in the world economy with lower and lower rates and more and more money, the worse the consequences will be. Instead of the private sector having a crisis, the governments will.

What we really want to know is, at what level of debt, deficits, inflation and general economic misery will the policy of inflation and government spending be abandoned? At what point do interventionists figure out that they’re wrong? Their argument that more must be done could be made infinitely.

We’ll find out just how far there willing to go. In the meantime, you have to invest your wealth. Dan Denning reckons there will be a better buying opportunity than today for Aussie investors though. That’s because the boom that made him move to Australia in the first place is ending.

Nick Hubble is a feature editor of The Daily Reckoning and editor of The Money for Life Letter. Having gained degrees in Finance, Economics and Law from the prestigious Bond University, Nick completed an internship at probably the most famous investment bank in the world, where he discovered what the financial world was really like. He then brought his youthful enthusiasm and energy to Port Phillip Publishing, where, instead of telling everyone about The Daily Reckoning, he started writing for it.
To follow Nick's financial world view more closely you can you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails.

Figure it out? They’ve known all along. On the timing, when there are enough degrees of separation and plenty of geo-political distraction.

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